Snake Lying in the Grass - Unexpected Recapture In a 1031 Exchange

(Listen Here 4:57 min)

Normally in a 1031 exchange, you defer all of your capital gains (both from appreciation in value and depreciation deductions taken over the years) by acquiring a like-kind replacement of equal of more value; and equal of more equity.

In Tax Law – Nobody Wants Surprises

There are some situations when the relinquished property will have some tax complications (snakes in the grass) that could cause you to unexpectedly  recognize gain.  To make matters worse, the surprise gains could be characterized as ordinary income and taxed at higher rates than mere capital gains rates.

What Do You Need to Check Out?

Here are some things to check out with your CPA, accountant or tax attorney:

Tax Credits

When Congress wants to encourage investors to do something…they provide tax incentives.  One of the most effective tax incentive is to offer tax credits.  Tax credits are more valuable than mere deductions because they off-set your tax liability dollar-for-dollar. The problem is that tax credits on your relinquished property for either  “rehabilitation expenditures” under Section 47; or from “low income housing” under Section 42 may be recaptured. Both of these Tax Code Sections allow for recapture of the amount of the tax credits.  It is always prudent to check with your accountant BEFORE you sell…just to make sure you do not have any problems with old tax credits.

Special Recapture for Rapid Deprecation

If you were able to take rapid deprecation under Section 179 or you qualified for bonus deprecation for investment in the Gulf Opportunity (GO) Zone areas impacted by hurricanes Katrina, Rita, and Wilma, then you need to check into the recapture provisions of those specific programs if your property ceases to be Qualified GO Zone Property.

Section 1245 Gain

Cost segregation engineering studies are often used by property owner to peel out those components of a piece of real estate that can be more rapidly deprecated.  A typical commercial building is deprecated over 39 years.  That is a long deprecation schedule.  A multi-family apartment building can be deprecated over 27.5 years.  Certain components of real-estate can be re-classified and more rapidly deprecated over a 5..10..15 year schedule. Those components can cause you to have recapture, unless you are mindful and when you buy your replacement property you buy qualifying property that matches up component for component with those Cost Segregation properties that were more rapidly deprecated.

Conclusion

Be on the look out for recapture that could spoil your 1031 exchange.  Talk to your CPA or tax advisor and have them run a projection to make sure that there are not any snakes lying in the grass…waiting to give you the tax bite.

About the Author:

Jeff Peterson (AKA: "Professor 1031") is a Qualified Intermediary and Serves as an Adjunct-Professor for the William Mitchell College of Law (Where He Teaches About Federal Income Tax). Jeff Works With People From All Over the USA to Save Money on Federal Capital Gains Taxes.

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